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The market dropped today; the SP was down 1.91%, the DJ Transports index broke through a support line on a chart and reached new lows for the year. The ValueLine Geometric index (Ticker VALUG) broke through 500 and closed down at 493, slightly below its 1998 and 2007 highs. The sharp decline destroyed its uptrend and started a new downtrend. The index is not adjusted for inflation and doesn’t consider dividends. If one netted a dividend yield of 2% against a roughly similar amount of inflation then the inflation adjusted total return since 1998 (when it was trading at 500 points) was zero for the stocks in the index. Finance theory teaches that stocks should provide an Equity Risk

Yesterday the bond market priced in a 3 year inflation expectation of 1.4%. Today the CPI data was released: My favorite measure, core inflation, ex-shelter rose to 1.53%, near the 2016 high of 1.6%. I maintain that shelter is measured incorrectly, forcing those who live debt free to calculate a hypothetical cost as if they were paying market rent for their residence – ridiculous! The Fed’s PCE inflation measure tends to reduce this problem which is why PCE is usually 0.25% lower, although it could be even lower. YoY the core rate was 2.1%. Shelter was 3.2% YoY. Core commodities were up 0.2% YoY. The dominant economic paradigm of the past 30 years has been globalization where capitalists constantly

The yield curve has become inverted for the spread between the 2 year and 5 year Treasury. The entire yield curve has shifted to be close to being inverted. Traditionally it takes a long time, perhaps 1.75 years after yield curve inversion before a recession starts. However, since the 2008 GFC the extreme manipulation by central banks, such as the QE program, that have never before been experienced, means that things will not act as they typically do during a yield curve inversion. Assuming the short end of the yield curve (for maturities under two years) is heavily manipulated by central banks and less so the further out one goes from short term maturities, then the traditional metric that

Stocks crashed hard today. The Russell Small cap index was down 4.43%, the SP down 3.24%. The ten year Treasury yield dropped to 2.91%, far below the recent high of 3.23%. The 10 - 2 Treasury spread narrowed to 10 bps, it had been in a range of 22 to 32 bps for the past year. At this pace the Treasury 10 – 2 spread will be inverted, a classic sign of a recession. Investing in stocks in the past decade has been dominated by the psychological aspects of technical trading, including “momentum”. But now momentum is broken, or soon will be. Many bullish investors may secretly feel stocks are overpriced and once the momentum trading turns against the

Yesterday’s pseudo-capitulation by the Fed chief during a speech was interpreted by the market as a sign that the Fed is very close to ending its rate increasing campaign. More experts are tilting towards the possibility of recession next year. If recession comes then yields will drop, in which case investors who own money market funds would miss out on the chance to lock in intermediate term yields. When yields drop deeply then bond issuers refinance (they “call” the bond in) and investors are then forced to reinvest at lower yields. An exception to that is that Treasuries have lifetime restrictions and Munis usually have 10 year restrictions on calling in outstanding debt. Assuming that the paradigm that recessions

I calculate the appropriate interest rate by using the ten year Treasury Note’s real yield, now 1.09%, and subtract that from a historical average benchmark of 2.08%. The difference is 0.99%, which is the amount of real increase needed to return to “normal”. However, one “little” problem: we can’t return to what used to be normal because that would require returning to a pre-GFC 2008 crash era when the EU and Japan had far less debt and no zero rate or negative rate programs. A second “little” problem is the extremely weakened ability of workers to go on strike and demand wage increases means that employment (the alleged threat to bonds) is intrinsically weak compared to several decades ago.

The Federal Reserve is boxed in. If it raises rates that will make the dollar go up too much, causing a global recession. If it raises rates that can trigger a domestic recession. If it tries cut rates to stimulate the economy that could set off another bogus stock market rally. If it tries more QE in the next recession that risks damaging the Fed’s credibility that they deviated from their goal of selling of QE-purchased assets, and it will make rates go up because of fear of inflation. If it changes things dramatically that can disrupt plans of consumers and businesses thus tilting the economy towards a lesser degree of growth. QE is actually deflationary because it destroys

Quantitative Tightening (QT) is a plan by the Fed to sell off its bond holdings to undo their acquisition of bonds during Quantitative Easing (QE) of 2009-2014. These sales or portfolio run off will be done gradually over several years and was started 13 months ago. The disposition is to be done by selling off or allowing portfolio “run off” of 15% a year of assets starting in 2020 and ending in December, 2025. The pace is scheduled to be increased next year to 15% of assets; the first year was at a smaller pace. Ben Bernanke said QE lowered rates 0.85%, other people have said it lowered rates 0.5%. Assuming we use Bernanke’s figure of 0.85% and the

Bloomberg BW ran an article July, 2018 saying B of A said aggregate QT globally from all central banks will be 4% over next 2 years (2% a year). My opinion: that’s almost nothing if someone adjusts for 2% annual inflation, or perhaps it is a 2% real shrinkage of debt over 2 years assuming a 1% global Developed country inflation rate since inflation is low in the EU and Japan. Assuming much of the debt has an intermediate term maturity or a due on sale (of the collateral real estate) clause for mortgages, then the debt will experience portfolio runoff through natural paydowns of principal by borrowers. If Fed does nothing the portfolio will naturally shrink gradually. The

Adjusting interest rates for inflation to find real yields is vital to understanding bond markets. But what about taxation adjustments? If an investor during the 1951-1965 and 1990-2008 eras of “normal” inflation rates bought a ten year Treasury bond they might typically get a 5% yield when the CPI was 2.5% and they paid 35% to federal taxes, leaving them with a 0.75% after-tax and after-inflation yield. Today they might find a 3.06% 10 year Treasury yield, less 22% tax, provides 2.39% after-tax and if they subtract CPI of 2.1% then they make about 0.29% net yield. The housing component of CPI is wrongly constructed and probably will go down when a surplus of newly constructed real estate